What is the status of the Ukraine situation? How could the various outcomes affect portfolios?

March

31

As with any geopolitical conflict, this is a fluid situation, with plenty of speculation.

As we outlined a few weeks ago, the Russians have a vested interest in securing their military and economic interests in this part of the world, including a warm-water port for the Russian navy fleet, a clear path for natural gas transmission to Europe (where Russia supplies a quarter of the supply), as well as a geographic ‘buffer’ zone of influence between Moscow and the Eastern edge of Europe which has historic and practical significance. In the U.S., we don’t often think of this geographic positioning issue as often (with the oceans as major buffers), but with the legacy of two nasty world wars in the last century, Russia hasn’t forgotten.

Despite the collapse of the Soviet Union twenty years ago, big brother Russia has continued to enjoy a good deal of influence over its former brethren, and is reluctant to let go. Especially as the European Union, NATO and less formal European trade linkages have been eager to fill in the void (and many of the former Soviet regions see freer markets and hopes for improved prosperity that go along with the Western alignment). The Russians currently stand with anywhere from 40,000-80,000 troops near or in close proximity of the Ukrainian border, which has locals and world diplomats quite nervous.

At the same time, it may not behoove Russia to act to the extreme. With their own close economic, financial and trade ties to Europe, drawing anger from the global community resulting in additional and harsher sanctions doesn’t benefit them in the least. Their economy, despite being the 8th largest in the world (2012, per the IMF), is heavily dependent on exports of petroleum, forest products and other natural resources and doesn’t feature a well-developed segment of internally-generated manufacturing or services. There are a number of reasons for this, not the least of which include some internal ‘inefficiencies’ (political system, large state-owned firms, high corruption levels and spotty ‘rule of law’ enforcement), so the nation is sensitive to shocks. In fact, harsh sanctions could push them right into recession and an even cheaper ruble.

On the other hand, turmoil sometimes acts in their benefit, since higher oil prices (somewhere in the $100-110/barrel range) increase import revenues and improve their trade balance, often causing the scales to tilt from deficit to surplus. The Russian growth rate has declined from 7% over the past decade to 1.3% in 2013, while the pace of inflation is over 6% and unfavorable demographics—including an outright population decline—add to the difficulty. So, there appears to be little room for error, and wealthy Russians have been moving cash to other more conducive locales by the tens of billions over the years. At the same time, Russian markets are and have generally priced in volatility and poor possible outcomes, with P/E’s in the range of 5 (!)—cheaper than problematic Thailand, Egypt and Turkey.

Our direct portfolio exposure to Russia is generally limited to a few percentage points in several specific firms via our emerging markets strategies that offer better ‘franchise’ prospects, such as retail store chains and internet search, and there is a bit of natural gas transmission exposure as well. For the bullish out there, this could represent a good valuation opportunity (the ‘buy when there is blood in the streets’ quote attributed to Baron Rothschild in the 18th century and refers to a useful mindset we often forget at times like this). At the same time, it is important to not be myopic and disregard potential carryover effects to other markets. Sanctions could boomerang to European markets as well, due to exposure of continental firms to Russian business interests and the oil/gas that Russia is not afraid to use as a lever. Military conflict of any kind can be a market shock, but not in every case for a protracted period. Europe could see an impact, as could energy prices, but these aren’t probabilities we plan to bet portfolios on.

It is almost always the “unknown-unknowns” that rattle investors as opposed to the “known-unknowns.” The bulk of strategists and portfolio managers we have contact with are not overly concerned about the Ukrainian situation from a financial perspective at this point. Some are actually seeing this as a purchase opportunity, per low valuations noted above, albeit perhaps not being too aggressive quite yet in doing so. No doubt there will be more to discuss on this topic.